Professional Documents
Culture Documents
Robert C. Merton
February 1980
ABSTRACT
Robert C. Merton
Department of Economics
Massachusetts Institute of Technology
Bldg. E52, Room 243
Cambridge, Massachusetts 02139
(617) 253-6617
ON ESTIMATING THE EXPECTED RETURN ON THE MARKET:
An Exploratory Inv~stigation
Robert C. Merton*
Massachusetts Institute of Technology
I. Introduction
Modern finance theory has provided many insights into how security
prices are formed and has provided a quantitative description for the
ai - r • ai (a - r) (1.1)
,This same basic model tells us t~at all efficient or optimal portfolios
(1.2)
-2-
(1.2) is called the Capital Market Line and (a - r)/a, the slope of
From (1.1) and (1.2), one can determine the optimal portfolio
allocation for an investor and the proper discount rate to employ for the
budgeting decisions. Of course, (1.1) and (1.2) apply only for the most
basic version of the CAPM, and indeed, empirical tests of the Security
Market Line have generally found that while there is a positive relation-
ship between beta and average excess return, there are significant
'arid hence, they provide a theoretical foundation for (1.1) and (1.2) not
a security will affect its equilibrium expected return, and indeed, for
. 5/
most common stocks, market risk will be the dominant factor.-
Thus, at least for common stocks and broad-based equity portfolios, the
estimating them. However, this effort has not been uniform with respect
gotten for free. Among the other parameters, beta is the one most widely
even human capital..§.! For practitioners, there are beta "books" and
beta services. While for the most part these betas are estimated from
time series of past returns, various accounting data have also been used.
whose only nonobservable input is the variance rate on the underlying stock.
As a result, there has been a surge in research effort to estimate the variance
. rates for returns on both individual stocks and the market. Although this
the expected return on the market and its standard deviation in order to
choose an optimal mix between the market portfolio and the riskless asset.
Indeed,· even if one has superior security analysis skills so that the
optimal portfolio is no longer a simple mix of the market and the riskless
asset, TreynJr and Black (1973) have shown that the optimal strategy will
still involve mixing the market portfolio with an active portfolio, and
the optimal mix between the two will depend upon the expected return and
investors in regulated industries requires not only the beta but also an
available time series will be much more accurate than the. corresponding
market were known to be a constant for all time, it would take a very long
(i.e., the difference between the realized and expected return) should not
. return and derive methods for estimating them. I also report the results
to motivate further research in this area by pointing out the many estima-
tion problems and suggesting directions for possibly solVing them. The
reasons for taking this approach are many: First, an important input for
estimating the expected return on the market is the variance rate on the
estimation models, their development has not yet reached the point where
alone are enough to warrant labeling the derived model estimates for
could be improved upon. Third, only time series data of market returns
The appropriate model for the expected return on the market will
any other information, one might simply use the historical sample average
tion. For example, we can observe the riskless interest rate. Noting
that this rate has varied between essentially zero and its current doub1e-
digit level during the last fifty years, we can reject the simple sample
the expected return on the market must be greater than the riskless rate
expected return on the market to depend upon the interest rate. Second,
the historical average is in nominal terms, and no sensible model would suggest
are handled by a second-level model which assumes that the expected excess
expected return on the market is estimated by taking the historical average excess
return on the market and adding to it the current observed interest rate.
with respect to estimating the expected return on. the market •.§.1
iuto account the level of inflation. However, it does not take into account
of risk associated with the market. At the extreme where the market is risk-
less, -then by arbitrage, a. = r, and the risk premium on the market will be
zero. If the market is not riskless, then the market mu~t have a positive risk
premium.
9/
While it need not always be the case,- a generally-reasonable
risk, the expected return must be higher. Given tha~ in the aggregate,
the market must be held, this assumption implies that, ceteris paribus, the
between one period and another, then higher market risk in the one
- the changes in market risk, then, at least locally in time, one would -
2
a. - r .. Yg(O' ) (11.1)
2
where g is a function of 0'2 only, with g(O)" 0 and dg/dO' > O.
2
known and that 0 can be observed. It is also assumed that there is a
2
set of state variables S in addition to the current 0 that can be
observed. The specific identity of these state variables will depend upon
the data set available. However, Y is not one of these state variables.
(11.2)
(11.3)
does not depend upon the current o2 . This condition, of course, does
2
not imply that Y. is independent of o . Thus, from (11.3), we can
rewrite (11.2) as
(11.4)
(11.6)
investor's relative risk aversion and the weights are related to the distri-
cation for expected excess return given by (11.6) which will be referred
time.
"Model In" makes the alternative assumption that the slope of the
Capital Market Line or the Market Price of Risk remains relatively stable
(11.7)
-11-
where Y2 is the Market Price of Risk. Like "Model 111," it allows for
cl,anges in the expected excess return as the risk level for the market changes.
appreciable periods of time even though the risk level of the market is
(11.8)
constant through time, then all three models would reduce to the state-of-
the-art model with a constant expected excess return. However, from the
work of Rosenberg (1972) and Black (1976) as well as many others, the
hypothesis that the variance rate on the market remains constant over any
MOreover, given that the variance rate is changing, the three models are
condition (11.3), then the other two models cannot. To this, note that
_ j-i
Y - Yi[a(t}] for i,j = 1,2,3. Therefore, if Y satisfies (11.3),
j i
then E[Yjls] = E[Yils]E{[a(t)]j-ils}. E[Yjls,a2(t)] = E[Yils] [a(t)]j-i.
Therefore, for i + i, Y
j
can only satisfy (11.3) if
if for the available data set, the variance rate can be estimated more
variance rate can be more accurately estimated when the market return
of both Rosenberg (1972) and Black (1976) show that a nontrivial portion
simple models. Further, along the lines of Latane' and Rendleman (1976)
of the type which satisfy (11.4) hold out the promise of better estimates
for the expected return on the market than can be obtained by direct
we have yet to specify how aCt) and Y., j = 1,2,3 change through
J
time. Although aCt) changes through time, it is assumed to be a
slowly-varying function of time relative to the time scale of market
riskless interest rate can be treated as constant over this same finite
time interval h.
Y = yi[a(t)]j-i, i, j
j
= 1,2,3 if one of the models satisfies this
Let ~(t):: Met + h}!M(t) denote the return per dollar on the
conditions for the dynamics of a(t) and Y , we have from (II.5) that
j
conditional on knowing M(t), a(t), and ret), ~(t) will be lognormally
distributed. [t+h ]
Let R(t):: exp ~ r(s)ds denote the return per dollar on the
(II. 9)
t+h
where Z(t;h) - J( dZ is a normally distributed random variable with
mean equal to zero and a standard deviation equal to~. Moreover, for
all t and t' such that It' - tl ~ h, Z(t;h) and Z(t';h) will be
independent.
Let T denote the total length of time over which we have data. The
each of these neT) time periods. The second step is to partition each
Because within each of the neT) time periods, the subperiods are
th '
redefine the symbol "t" to mean "the ~ subperiod of length' h" within
(a) the posited stochastic processes are time homogeneous; (b) the
length of the subperiods are the same for all n(T) time periods; and
(c) the neT) time periods are nonoverlapping. By the choice for time
th
units, "t" will also denote the ~ observation within a particular
time period.
t = 1, ••• ,N (IL10)
are nonoverlapping, g(t) and g(t') will be independent for all t and
t' such that t ~ t'. For the N observations within this time period,
"'.
Model II: Y
1
= (II1.2.l)
(III.2.3)
From (111.1), all the conditions for least-squares are satisfied, and
therefore, '"
Y appears to be the best linear unbiased estimator ofY .
j j
Since realized rates of return on the market can be negative, it is certainly
possible that for a particular time period, Y could ·be negative. In such a
j
case, is that value for Y an unbiased estimate of Y ? From prior knowledge,
j j
aCt) ~ ret) must be positive. Therefore, each of the Y must be
j
positive, and the answer to the question is "no." Thus, (111.1) is not a
-17-
data. The specific prior chosen is the uniform distribution so that the prior
density for Y
j
is given by f(Y )
j
= lIb where 0 ~ Y
j
~ b.
from (111.1) that the X'(t), t = 1, ••• ,N are independent and joint
(111.3)
., (111.4.1)
N
rl _ L [cr(t) ]4-2j ., (III. 4. 2)
j 1
Pj == OJ (b - Aj ) and nj == -AjOj •
By inspection of (111.3) and (111.4), the way in which the data enter
(111.5)
-18-
parameters Y and
j
As Figure 111.1 il1ustrates t the posterior density function will be a
"
=Y
j
for o ~ Y" j <b (111.6)
. .. A
. . . . ..... ..)J 4: 0
..._~
...... . .=0
.
y..)
o b
o b
)J >b
._ .Y:=b
y.
J
o b
-19-
E[a(t) - ret) la2 (t) ,S] = E[X(t) + .5a2 (t) Icr2 (t) ,S]
= [cr(t)]3-jEIYjlcr2(t),S] (111.7)
the distribution for Y.. From (111.7), it therefore follows that the
J
correct estimator to use for estimating the expected excess return is the
_ "2
As is derived in Appendix B, Y
j
= E[Yj Iyj,nj;b], j = 1,2,3, is
given by
(111.8)
distribution.
." i
From (111.6) and (111.8), the relationship between Y , Y , and Y
j j j
for a finite number of observations can be summarized as follows:
-20-
"
Y > yR. > Y for "
Yj ~ 0
j j j
R. " "
Y = Y = Y
j j j
for Yj = b/2 = Y
j
(111.9)
Y < yR. =
j j
ij for b/2 < Y
A
j
~b
In this section, market return and interest rate data from 1926 to
1978 are used to estimate each of the three models presented in Section
II. The model estimators are the ones derived in Section III. The
Index are used for the market return series. This index is a value-weighted
portfolio of all stocks on the New York Stock Exchange. The U.S. Treasury
Bill Index presented in Ibbotson and Sinquefield (1979) is used for the
~iskless interest rate series. The monthly interest rate from this
index is not the yield, but the one-month holding period returns on the
the market can be treated as constant was chosen to be one month. The
and one month is, therefore, the observation interval. The choice of
value for the length of the time period over which Y is assumed to be
j
..22..
holdings of various types of assets such as those used in the Blume and
relative risk aversion over time. However, given the explorato.ry nature
of this investigation, the route taken here is simply to estimate the models
assuming different values for T ranging from one year to fifty-two years
and to examine the effect of these different choices on the model estimates.
market return data used to form the posterior cannot be used to form an
aggregate risk aversion from the investor data used in the previously-
cited Blume and Friend study might provide some basis for setting b.
is a diffuse prior on the nonnegative real line with b = 00. Taking the
(IV. 1)
-23-
the bulk of the empirical analysis, some estimates are provided for
variance estimation model is used. The use of estimated values for the
estimators. Given the exploratory nature of the paper and the relatively
Section III, it is assumed that the estimated variances are the true
values of the variances. This is the principal reason why the empirical
the monthly variance is the sum of the squares of the daily logarithmic
returns on the market for that month with appropriate adjustments for
weekends and holidays and for the "no-trading" effect which occurs with a
•
-24-
portfolio of stocks. Unfortunately, daily return data for the NYSE Index
not a long time series. Therefore, to make use of the much lonper monthly
market for the six months just prior to the month being estimated and for
the six months just after that month. That is, the estimate for the
"2
variance in month t, cr (t), is given by
"2
cr (t) = L
{ 6
(In[~(t+k)])2 + L:6 (In[~(t-k)])] } 112. (IV.3)
k=l . k=l
With this variance estimator, all the available market return data except
the first six months of 1926 and the last six months of 1978 can be used
is prOVided by estimating the models using both the daily return and the·
monthly return estimates of the variance for the period July 1~62 to June
1978.
In Table IV.l, estimates for Model 111 are reported for the two
YI(YI ~ b!2), the data have little weight in the posterior estimate Y •
I
For this reason, with b
small, the differences in Y for the two
I
different variance estimators are quite small. As b is increased,
the data have greater weight in the estimate of Y and the effect on
I
YI of the different variance estimators also increases. Figure IV.l plots
--- ~ - __ ..
. __~ .. ..
balance of the paper. That is, only the nonnegativity prior restriction
differences in the posterior estimates are somewhat smaller than the per-
centage differences in the unrestricted regression estimates for both
Models #2 and #3. However, for all estimates in these latter two models,
Daily Data Estimates 0.3733 1.5181 0.2598 0.5312 1.0612 1.5045 1.8054 1.9605 2.0173 2.0341
of Variance
Percentage Dif- -6.72% 4.83% -0.04% 0.0% 0.39% 1.13% 2.12% 3.10% 3.76% 4.12%
ference
, ;;,
}
, , ,
FIGURE IV.~ TIfE EFFECT of PRIOR IA.rreR-60lUJD RE:>TRICT'OtJS OM MODEL E5TIH~T£1 ~(b)J
us,,.,c; I>AIL'i DATA f~T'HAT'S OF MONTHL'( VARIAtJCE'
.JUL~ l~fD~- 'J'C.UJE let7B
~(b)
3·0
)
=l.S
,
"
1\
_ _ _ ' _ . _ _ --..-;._ ---fJ"-- ~ ~_ -l1_=--1€lB1.. . _~_
j i.!
_._.:
. I -- r
, '
, ,
1
I
' ,1.0'
_... _- .. ~.
.j .
o r I I I I I ••• I • I I I' b
o O.S 1.0 1.5', -1.D :l.S, 3.0 3.5" ...... 0 1·!, 5.0 "S.S, '.0 '.5,
Table IV.2
,
R
••
• ,••
•I •l- . . DAILY &~TU1ATE
•I I OF MONTHLY VARI"~C{
.. .
-
I
.. '..,,,,,Y_.
I
I : ,a NOIINEGAT.vE PRIoR.,
:
" .
Re$TRICTloN ONLY
·'0
I
• ' ,i
Vi.'= I.S'111---.• : 2.01411 (b=oo)
i
- .,• '.,
•
•
••
I
.0 •
1-------I-+-.--ti----I------t....---+--==:::;.-::=--.... '11-
0·0 1·0 S.O '.0 7·0
+_
• ,_:- • __ ~ •• _ . _~A'"
,
.... :..._." .. -.- ; ...
. ,
J--:-
·
, I .
,
· I MOm'HL Y EST'MATE
· I . OF MOIJTHI..Y VARIANt!
I .
· I·'
· I . NON tlEGATIV£ PRIOR.
I
I · I .RESTR.ac:.TlcN ON" Y
,. I I . .<.. b=oo)
Yj.=l.seUi ~ ~Yi.: %.1110
I I
I l
I . I
I I
I . I·
I
o--+-~t.HO--3-4.-0--41 ....-0-·--s+.0--=:::'+='"0::::::=='-'-+7./ 1
·0 . o,&...o-.--.....
i
.. _ - ,--~. -. _ ,., -.. .~. - .." .-.. '--""".,-, _. ..
F.GIlRI IV. '5 PO'TER,olt PROSABILITY DiSTRIBUTION FOR Va.
=
MODIL # 2. : o((i)-t-tt) Va. O""lt)
Jw.y 11t-1- "JUliE 'f7'
. NOtJNE~"T'v£ PRIoR.
R&STR'C.T'OAI ONLY
(b- 00) .
0-10 0·$0
MONTH..Y eSTIMATE
1~o
OF NoN'httY v"'lAtleS
0·30 0·10
POSTER'oR. PROBAalUTY DI$TIU 8L1T'O~ FoR. Y.
MoO'1. # S: ot(t)-rLt):= 'is
___ _ . __ _ . 3"IlLY ., '1- :r...". '1"
_•... __ ._._,_ .... _._. __. .. _. _ _ ._... _.. .. •._._. r o ' __ ' •. _ . - • • • • •".
.
~
,
_
~
.
-
~
_
.
_
-
,
,so-o
__ _DAII.'t e,r'"ATE
_ _____. __ OF "0"'11a. y ",,,,.AIICE
I
I . __ . R&STIUt.T,olJ OHI.Y
I _ .(b :.0)
I
I .
I
I
A I
Yr·oot~Ys=·OO8.t
- ~oo-o
- ISO'O
"'OF' TMo-,THLY
NI.'1 VAR,lUIcG £ST'HAT£
YS=.OOS%"'tVYS: .00SI
-0·0
o-ooso O· 010..0 0-01 SO O-OZOO
-26-
the three models are illustrated in Figures IV.2, IV.3, and IV.4.
of the models.
From Table IV.2, it appears that for this period, the prior nonnega-
tivity restriction is important only for Model #1 where for the same
estimate and the unrestricted regression estimate for Model #2 and Model
,--
regression estimates are examined for fifty-tvlO years of data from
July 1926 to June 1978. These estimates are presented in Table IV.3
#3 with T = 26. For Model #1 with T = 26, the differences are small
with an average about half of that found in the previous analysis from
"
Y .1867 .2012 .1723 .1867
2
,/
Y .1867 .2012 .1725 .1869
2
"
Y .0082 .0109 .0068 .0089
3
-
Y3 .0082 .0109 .0068 .0089
.. ....•t.o
I
I
I
I
•I
·········10 I
•I
. NOH IIIGAT'VE PRIOR.
I
I . "STRIC.T'ON ONLY
•I ..._.._...( b. CO)
/ ..
. I ..
II> . I
\:I.I'1t,-~1'11.1"r
I
.... .. ·0
Ys.
0'0 3·0 1-0 s·o "·0
·S'·O
NoN NEGAT.VE PR/ott
RISTRIC.TION OIlL Y
t
(b= (0)
I
I
I
A ,_
'1t:""~I.,...YI.:.llc."7
.....-_IIIIt:;..~ .......__ ~~-._ .....__ ~.....- __......_ YI.
. 0·0 0 · '0 0 · ao 0 · SO tJ • 410 0 · 50 0· '0
. "-_ ..- _
..•......•. ' .~..:._, - ... -- .. '. _.. _. -', -, ...... - -- .-- .. --- .. _ .._-- .. -._.". _. _. ".
FI6UR£ IV.1 PoSrlRloR. PRolABIUTY DISTR'.WT,oN FoR. Ys
'NODaL # I: ottt)- rlt): Y.
_._. _. ... . . JULy ",,,- 3'Ur4E Ict."
- -t.o·o
.- 0-0
.
l=.ootl
I ...
-
y~.ooal
..,s
0·0 o· 0050 0·0100 0'0,50 0·0100 o·oaso
---"'--'--'- -'-- ._.. - _.~ .---.. _._..- -~ ...•.. -. --~-- -- .-.- - ~. __ .- ".•--- .- •.. -.-._ .." .'.f"-- .-. -
~ -•• -'" -. , '." ..
- .'
I
•_ ......•.....•.._ •. _.__ , ...•....... ~ _~_. ._._~_ . _ . __ ."._. ._0_ .• ~_.,., 1.
-27-
between Y. and Y. for the four l3-year time periods ranged from
J J
a high of 28 percent for Model /11 to a low of 6 percent for Model f!3
percentage differences for each of the time periods are more important
substantial for all three models. This was a period with a number of
did not have these large negative realized excess returns and corres-
Model /11; small for Model //2; and negligible for Model //3. However,
Table IV.4
-
Y2 .• 1617 .2457 .2983 .0840 .1974
the results from this period are consistent with the others. This was
the early 1930's when the market had a large negative average excess
unlike "
Y in which each observed excess return has the same weight,
l
Y puts more weight on observed excess returns which occur in lower-
Z
than-average-standard-deviation months and less weight on those that
of the regression estimator for Hodel 113 will show that the weighting
either large negative excess returns occur in months when the variance
provide the estimates for all three models for T =4 years (N = 48).
In the 1930-1934 period, the regression estimates were negative for all
when T is further reduced from four years to one year, the effect
are compared with the corresponding estimates for the period 1965-1978.
Table IV.5.1
a(t) - r(t) = Y3
x
Percentage
~i3 Y
1
Y
3 Difference
Since the variance estimates and return data axe identical for the l3-year
presented in Table IV.2 and those presented in Table IV.4 reflect the
the realized excess returns on the market were mostly positive .and the
For Model #1, the effect of this change on the posterior estimate
very long time series are not always available, and even when they
Y ., (j
j
= 1,2,3), were constant over the entire period 1926-1978, and
with the variance estimators and the exploratory spirit with which
the sample average of realized excess returns over the longest data
period available.
Using the estimated Y. and the time series of estimates for the
J
market variances, monthly time series of the expected excess return on
- the market were generated for each of the three models over the 624
months from July 1926 to June 1978. As shown in Figures IV.5, IV.6,
and IV.7, with T equal to 52 years, the posterior density functions
for all three models are virtually symmetric and the differences between Y.
J
and Y. are negligible. Hence, for T = 52 years, the monthly time series
J
of expected excess returns using the unrestricted regression estimates
in Table IV.7 and they include the sample average, standard deviation
-32-
and the highest and lowest values. Of course, the expected excess
the same summary statistics are presented for the realized excess
returns on the market and for the realized returns on the riskless
asset.
percent per year. The "Cons tant-Price-'o f-Risk" Model 112 is the
10.36%. The sample average of the realized excess returns on the market
was 0.655 per.:'-ent per month, or, annualized, 8.15 percent per year •.
This sample average is also the point estimate for the expected excess
on the market is much larger than the variance of the change in expected
return. That is, the realized returns are a very "noisy" series for
be tempted to conclude that Model III "looks" a little better because its
Table IV.7
Model /11: aCt) - ret) = Y1C1 2 (t) 0.665% 1.032% 7.161% 0.048%
Y is such that this must always be the case when the variance estimator
l
is of the type used here. This observation brings up an important issue
it takes into account the current level of risk associated with the market.
constant, or at least, stationary over time. From Table IV.7, using the
change in the variance rate when estimating the expected return on the
market, we close this section with a brief examination of the time series
of market variance estimates. The average monthly variance rates for the
market returns are presented in Table IV.8 for the thirteen successive
four-year periods from July 1926 to June 1978. Over the entire 52-year
period, the average annual standard deviation of the market return was
variance rate can change by'a substantial amount from one four-year
Average .003467
more volatile in the pre-World War II period than it has been in the
annual standard deviation of 27.9 percent for the period July 1926 to
June 1946 versus 13.8 percent for the period July 1946 to June 1978.
rate, the large differences in variance rates among the various subperiods
th~ estimated Market Price of Risk based upon the other forty-eight
estimator. However, this same exclusion caases Model #2's estimate, Y2'
V. Conclusion
results: First, whether or not one agrees with the specific way in
the empirical results presented here, estimators based upon the assumption
when the time series are as long as fifty years. As demonstrated by the
analysis of :Hode1 113, these conclusions apply even i f the model specifi-
cation is such that the expected excess return does not depend upon
these lines may prove fruitful. First, because the realized return data
of such other data are the surveys of investor holdings as used in Blume
and Cragg (1979); and corporate earnings and other accounting data as
used in Myers and Pogue (1979). Because these types of data are not
study.
A second direction for further study is the length of time over which
models should benefit from inclusion of both option price data and
Perhaps other market data such as trading volume may improve the estimates
as well.
this paper will stimulate further research effort and with it, some
FOOTNOTES
*Aid from the National Bureau of Economic Research and the National
Science Foundation is gratefully acknowledged. My thanks to F. Black
and J. Cox for many helpful discussions and to R. tl~nriksson for
scientific assistance.
2. See Jensen [1972]; Black, Jensen, and Scholes [1972]; Fama and McBeth
[1974]; and Frien.d and Blume [1970].
Appendix ~
realized returns than can the expected return. We now show that this
thesis that the mean and variance are slowly-varying functions of time,
Suppose that the real·ized return on the market can be observed over time
during a typical period of length h for k = 1,2, ••• ,n. From (11.5),
Xk can be written as
- [ ~~] Ih ,
'"
II will have the properties that
'"
E[ll] = II (A.2)
and
'"
Var[ll] = (i/h (A.3)
only upon the total length of the observation period hand not upon
intervals for the returns and thereby, increasing the number of observa-
~2 _ [~~] Ih. From (A.l), this es timator will have the properties
that
= cr2 + 112h/n
and
"2 = 2cr4 In + 411 2h/n 2
Var(cr ) (A.5)
2
For example, typical values for ~ and cr in annual units would be
~.10 and 0.04, respectively. For daily observations, hln will equa1_
also, of course, saves one degree of freedom. Thus, for stock return
data and observation intervals of a month or less, the bias from a non-
More important than the issue of bias is the accuracy ?f the esti-
"2
mator. As inspection of (A.s) quickly reveals, Var(cr ) does depend
To further emphasize the point, consider the extreme case where both
the mean and variance are constant for all time. The accuracy of the
calendar time for which return data are available (e.g., 52 years).
The standard deviation of the variance estimate using annual data will
A4
the estimate using daily data over the same calendar period. Since
neither the mean nor the variance are constant for anything like this
daily data while the estimates for expected return taken directly from
p. 336-339].
infinity for any finite h, and therefore, the variance rate could in
This error is caused by not knowing the exact length of time between
stock as reported in the newspaper was not the result of trade at 4:00
PM, but rather the result of a (last) trade which occurred at 3:00 PM.
If ~ is one week and if the last trade the previous week did occur
at 4:00 PM, then the observed price change occurred over a 167 hour
interval and not a 168 hour interval as assumed. While this actual
the magnitude of the error is only 0.6 percent. However, suppose that
~ is the six-hour interval from the 10:00 AM opening to the same day
AS
4:00 PM closing. Then, even if the first trade occurs at 10:00 AM,
the actual interval for the observed price change is five hours and not
six, and the magnitude of the error in the variance rate would be 16.7
percent. Of course, if the first trade actually took place at 11:00 AM,
then the error would be 33.3 percent. Thus, the "true" time interval
the stocks in the portfolio will not have their last trade near the
closing time. Since the closing value of the index is computed using
correlation is not "real" in the sense that one could make money trading
trades could not have been executed at these last (and earlier) prices.
the sum of squared daily logarithmic changes in the index 'will produce
which is the true change. Since it is not known for how many days this
'" ..
~ = ~~ + aV'K [oOE:k + 01E:k- l + 02E:k-2 + 03E:k _ 3 ] (A.6)
we have that
(A.7)
In Section IV, daily data are used in one of the variance estimators
for the period July 1962 to June 1978. To adjust the estimates for
(A.8)
(A.9)
A7
made for nontrading days (i.e., weekends and holidays) by dividing the
"daily" returns by the square root of the number of days between trades.
ABl
Appendix B
uniform with f(Y.) = lib for 0 < Y. < b and zero, otherwise.
J - J-
Because the {e:(t)} are independently and identically distributed
standard normal, the joint density for XI(l), ••• ,XI(N), conditional on
(B.2)
1
- -2 QJ' 1 2 2 N/2
=e exp[~ -2 Q.(Y.-X.) 1/(2rr)
J J J .
and· n2.
~&J
and '\
I\j
By Bayes Theorem, the posterior density for Y. given Xl (1) , ••• ,Xl (N)
J
can be written as, j = 1,2,3,
(B.3)
b
1 2
.= exp[- -2 Q.(Yj-X.) 2
1/ i 12
exp[- -2 Q'(Yi-Xj) 2 ldy .•
J . J . J J
o
AB2
that
p.
-[ { .- "21 u 2 du ] tn
j
(B.4)
= 2n {~(p.) - ~(n.)} In.
J J J
where Pj =n.(b
J
- A.)
J
and n.J =-A J.nJ.• By comb ining (B.3) and (B.4), we
Bibliography
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Inflation: Year-by-Year Historical Returns (1926-1974)," Journal
of Business 49 (January), pp. 11-47.
13. Jensen, M.C., 1972. "Capital Markets: Theory and Evidence," Bell
Journal of Econ01llics and Management Science 3, pp. 357-398. --
B2
15. Lintner, J., 1965. "The Valuation of Risk Assets and The Selection
of Risky Investments in Stock Portfolios and Capital Budgets,"
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